These days, it's hard to avoid President Mahmoud Ahmadinejad's pronouncements on foreign policy. But he also takes a keen interest in culture. "The art of theatre," he writes, in the programme for the 25th Fadjr international theatre festival in Tehran, "should represent the best and most beautiful definitions of human truth-seeking and worthiness." Well, there's certainly a strong strain of truth-seeking in the theatre I see during a week's visit to the Fadjr festival. But the trip also affords a much more complex picture of the country than you'd ever glean from Ahmadinejad, or indeed from Bush and Blair.

Set up in the years following the Islamic revolution, Iran's theatre festival only recently went international, thanks in part to the liberalising influence of Ahmadinejad's predecessor, President Khatami. In 2003, Dundee Rep became the first British company to visit the Islamic Republic, with a production of Shakespeare's Winter's Tale. This year, the festival - which I attended under the auspices of the UK cultural exchange outfit Visiting Arts, who were leading a business strategies in the arts workshop - showcased drama from Germany, Russia and Turkey, alongside the usual programme of homegrown theatre.

The Iranian work ranged from the naturalistic to far-out abstraction to traditional Persian performance. There were plays called Agony, Chaotic Bitter Play, Torment Symphony. There were recurrent motifs of entrapment: flies caught in spider's webs; people tied up; Icarus imprisoned, dreaming of flight. Humour was in short supply.

This is partly because there is a tendency in Iran to see theatre as pure, serious - not a branch of the entertainment industry. It's also pragmatic: the funniest show I saw, Koroush Narimani's adaptation of Jaroslav Hlasek's Good Soldier Svejk, fell foul of the censors because it uses the character of an ex-Jewish Catholic priest to ridicule the mullahs.

Censorship is one of the major issues facing Iranian artists today. The government - or its theatre arm, the Dramatic Arts Centre (DAC) - will not license any production that is critical of contemporary society. I saw one play that painted a grim picture of military life during the Iran-Iraq war, but its staging was permitted only after the script had been changed, and the events relocated to a period before the revolution. I spoke to two artists, Siamek Ehsaii and Amir Reza Koohestani, a playwright whose Amid the Clouds debuted at the Royal Court in 2005. Both feared their next works would be blocked because they feature, respectively, suicide and the true story of recent multiple murders in Tehran.

The more fundamental restrictions, however, are cultural rather than political. "In Iran, we have all these limitations on how we use the body," says the actress Sara Reyhani. "Before we even move, we have to censor ourselves." Her interests, she says, "are in contact improvisation and dance. But we're not allowed to touch one another, and we're not allowed to dance." Nor is she, or any other actress, allowed to remove her headscarf. Reyhani currently has one arm in plaster, and she and director Arvand Dashtaray used this in a dance piece (or, to dodge the censors, "body theatre") in which a man and a woman flirt with the idea of touching one another. Eventually they do touch - but only through plaster.

Some young artists are extremely impatient with these taboos, taboos that also deter international companies from performing at the festival. Other more established practitioners downplay the censorship issue. "You have rules in your country, and we have rules in our country," says Atila Pessyani, the veteran director whose poetic, dissident drama The Mute Who Was Dreamed played in Edinburgh in 2002.

These rules are frequently bent, if not broken. And many artists believe that restrictions inspire greater creativity. "We think about ways to show something indirectly," says Koohestani. "And indirect ways can be more artistic." When I repeat this to Reyhani, the dancer, she rolls her eyes.

For most practitioners, the bigger problems are practical, not cultural. Iran has too few theatres, and too little money. "It's a real shame for a city of 12 million," says Mohammad Atebbai, the dynamic director of the DAC's international wing. "But we have just the City Theatre in Tehran, and only two or three more theatres besides." There is almost no private theatre funding, so the state dictates what fills those spaces. From 600 applications, the DAC funds no more than 100 productions annually.

And if you don't make that shortlist? "Iran desperately needs a privatised, entrepreneurial theatre culture," believes Atebbai.

As a result, many Iranian artists have concluded that the only way to make theatre pay is by appealing to the international market. This is a dysfunctional development, says Koohestani - not least because, having only recently been reconnected with world theatre after years of isolation, Iranian artists are ill-equipped to second-guess international tastes. "So you end up with not-what-Europe-wants and not-what-Iranian-audiences-want. You lose both your audiences."

Theatres tend to be full in Tehran, but only because there are so few of them. "So artists don't need to think about what people want," says Koohestani. He would make tuning into the domestic audience and putting faith in them his top priority.

In fact, there is a popular theatre sector in Tehran - small, self-supporting, and "all just cheap comedy", says Koohestani. "You know, they drop their trousers then: hahaha." But the artists I met wanted nothing to do with this, seeing art and commerce as separate activities. Many would rather follow in the footsteps of European experimentalists such as Jerzy Grotowski, Tadeusz Kantor, Peter Brook - all of whom visited the Shiraz Festival in the years before the revolution. Which is fair enough - but in Tehran, as Koohestani points out: "There are traffic jams constantly. People work hard. Who wants to come and see these plays?" According to Atebbai, both money and (although this is disputed) the government's will are in place to help build a thriving, independent domestic theatre.

Iranian theatre is not entirely beleaguered; there are reasons to be optimistic. Torn from its europeanised past into an uneasy theocratic present, braced for more change, Iran is a nuanced, more liberal place than one might expect. The most distinguished of its playwrights and directors are already internationally renowned. The winners of best play and best director at this year's festival - Hamid Reza Azarang's funny, poignant Iran-Iraq war drama, Fantasy on a Parallel Bar, and 26-year-old Homayoun Zadeh's grungy spin on Daedalus and Icarus - will surely follow suit. (Both the Manchester International Festival and Edinburgh's Theatre Workshop are currently planning Iranian seasons.) These are plays that deny, and will resonate far beyond, the pious, purist Iran of Ahmadinejad's - or Bush's - imagination.

"Fortunately," says Mohammad Atebbai, "culture is different from politics. And from a cultural perspective, I see two sides, both international and Iranian, eager for more dialogue." That's what I saw, too, in all those overflowing auditoriums where bright-eyed youngsters squeezed two to a seat, squatted in the aisles, crowded by the doorways, to hear what homegrown and international artists had to say.

Seventy per cent of Iran's population is under 30, Atebbai reminds me. "And this generation will be different from the previous one. They are not patient. They wish to reach out to their desires and to do so quickly - like everyone else in the world. They will play an important role, I believe. Very soon we'll see changes in all fields".